Exotic mortgages remain popular despite increasing risks

RachelKoning Beals

Such loan innovations allow home buyers to put little money down and make low monthly payments. They've also poured fuel on one of the hottest and longest housing booms in the nation's history.

But in the wake of the Federal Reserve's push to take away easy money, low interest rates and red-hot home prices have faded away. With them went the main conditions that made interest-only and other flexible mortgages worth their risks. So the consumer's love affair with such loans is drawing to a close now, right?

Wrong.

Far from just another financing fad, exotic mortgages have become such a fixture on the U.S. housing landscape that they've proven to be a key lever for many borrowers even as they have become a greater danger at the same time.

'Because homeownership is so critically important in financial security, these Americans are unwittingly putting their entire financial livelihood at risk.'
Allen Fishbein, Consumer Federation of America.

"In our changing market, from unprecedented low rates to a steady rising of interest rates, these varieties of loan programs have become much more popular," says Bill Callanan, a partner with Mortgage Management Systems, a San Francisco mortgage broker. "But if you're scraping nickels together, they're not for you."

While traditional long-term, fixed-rate mortgages remain the loan of choice for the majority of home buyers, more borrowers are also shopping for interest-only loans, pay-option ARMs and hybrid fixed-ARM loans.

That's particularly true in high-cost housing markets, where taking one of those loans may be the only way to afford a house.

It worked well when double-digit home-price gains built equity while leaving more cash in homeowners' pockets. Low interest rates muted the potential sting of upward rate adjustments.

But neither of those conditions exist today: Interest rates are well above year-ago levels and home-price gains have cooled or, in some of the hottest markets, already started to erode. Read more on home prices in major U.S. cities.

One big problem, says Callanan, is that household incomes haven't been rising as fast as interest rates, creating greater affordability hurdles for home buyers. Borrowers who use these loans now are challenged more than ever to gauge the health of home prices in their area and measure their ability to stay on top of payments, and to know when to refinance.

Paying off

For some, the gamble still pays off. Regardless of the health of the housing market, say mortgage experts, increasingly savvy consumers want more control over their own finances, including being able to invest money that would otherwise be tied up in a mortgage.

They say the mortgage market should never be viewed as one-size-fits-all process, particularly because few homeowners keep the same loan for more than a few years -- they either move or refinance.

"There's a risk-taking attitude," says Anthony Hsieh, president of Lending Tree.com, an online brokerage. "People aren't as motivated to pay off their home. Most people aren't in their home for more than five to seven years, anyway."

That penchant for added risk, including some mortgages that allow borrowers to vary their payments or skip a payment, has drawn several warnings from regulators and from consumer watchdog groups, who anticipate a shock to monthly budgets once the impact of higher interest rates is fully felt. For many, that time is coming soon.

'Fixed rates are a great deal right now. This payment offers stability and predictability.'
Greg Eckert, Centennial Mortgage

Since the Fed's two-year campaign to tighten monetary policy, there has been a pronounced effect on mortgage rates. The 1-year, Treasury-indexed adjustable-rate loan, for instance, has jumped to a national average rate of 5.68%, according to Freddie Mac, up from 4.26% a year ago and from a low of 3.39% in March of 2004.

Mortgage bankers concede that demand for alternative loans that reduce payments isn't as brisk as 12 months ago, in part due to the warnings. But marketing remains aggressive and mortgage lenders continue to compound the options: qualifying buyers now face an often confusing buffet of loans with terms of anywhere from 1 to even 50 years. Some of them can result in negative amortization -- an increasing monthly principal balance.

The complexity of these options can leave less-sophisticated borrowers at the mercy of lenders, who consumer groups charge are all too willing to entice home buyers with looser financing so that they may go after properties well out of their conventional reach.

"While the lending industry has characterized nontraditional borrowers as financially sophisticated and savvy consumers, the truth is that many are far from affluent and could be betting the house on their mortgage," says Allen Fishbein, director of credit and housing policy at the Consumer Federation of America. "Because homeownership is so critically important in financial security, these Americans are unwittingly putting their entire financial livelihood at risk."

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